You may rely on your gut feeling, intuition, or educated guesses in some critical decisions of your life. However, in real estate, only numbers and math should guide your choices. You may say - but I have an agent (or even agents) doing this work for me - and it's great you have a trustworthy agent, but verifying the data they provide will never be amiss. If you are a thriving investor, you will always want to make your own decisions about a property, location, market trends, and opportunities.
There are different ways to calculate the ROI and expected income from your property or cash investments. Let's look at some metrics you should take into account when evaluating your deal and how to calculate them.
1% (or 2%) test
Whether it's 1 or 2 depends on the market and investor choice; in some markets, like the US, 2% will be the best indicator, while in others, like Cyprus, with 2%, you hardly can find any deal, and 1% or close to it makes more sense.
This rule is the fastest rough evaluation of the deal on your property, which you can usually run in mind in just a few seconds:
$$ Monthly Income / Property Price $$
Where Monthly Income is what you have from your property monthly renting. No expense deduction is made here; it is just your gross monthly income. Property Price is the price you are paying for the property. The higher the result number, the higher the expected cash flow.
For example, if I buy an apartment for 150K that is expected to be rented at 1,5K per month, then by the 1% rule, I'll get:
1.5 / 150 = 0.01, which is exactly 1%, which means my deal looks solid.
It's a useful first evaluation rule of thumb for checking if your deal is bad or even for comparing several deals to decide on the better one. However, this rule doesn't take into account the complexity of real estate deals, such as mortgages, down payments, property management, repairs, insurance, and taxes.
So, let's consider another metric as the second line of defense in your decision-making process: the Property Cap Rate.
Cap Rate
Cap Rate is the rate of return on your property based on the income that the property is expected to generate and is calculated as:
$$ Annual Net Income / Property Price $$
Where Annual Net Income is Gross Income minus Expenses.
Cap Rates between 4% and 12% are generally considered good.
To get Annual Net Income from the property and its Property Price is easy - the first one is just your monthly rent charge multiplied by 12 months, and the second is the price you pay for the property.
To calculate the income from the property properly, you should know the fair market rent based on the property's location, size, and amenities. Here are some examples of fair market rent prices for Limassol.
However, how to evaluate the property expenditures is where many, even experienced investors are getting in trouble by underestimating the expenses. To simplify the calculation, we will use another rule of thumb - the 50% rule.
50% rule
This rule evaluates how much cash flow the property will produce, and it suggests reducing 50% from the cash flow generated by your property to all possible expenses - operating costs, taxes, insurance, management, and repairs.
For example, if you charge 2,000 monthly for renting your property, you will get an income of 1,000.
For example, if I buy an apartment for 150K that is expected to be rented at 1,5K per month, its Cap Rate will be calculated as follows:
1.5K * 12 = 18K - Annual Gross Income
18K / 2 = 9K - Annual Net Income by 50% rule
9 / 150 = 0.06 or 6%
Note: We didn't put mortgage payments in our calculation. If you have a mortgage on your property you should add it to your expenses as well since it's not covered by 50% rule.
CoC ROI
Another interesting metric the real estate investor should look at is CoC or Cash-on-Cash Return.
While the Cap Rate compares the purchase price of a property to the income it generates, the Cash-on-Cash Return (CoC) tells you how much return you make on the Cash you put in this deal, and it's calculated as follows:
$$ Annual Net Cash Flow / Invested Equity $$
Annual Net Cash Flow is similar to Annual Net Income, just in this case, it's pre-tax amount and can be calculated as:
$$ Annual Gross Cash Flow - Expenses $$
Invested Equity is different from Property Price in the CapRate calculation formula and includes the down payment you put down on your purchase, loan points, and closing costs.
For example, let's say I buy an apartment for 150K that is expected to be rented at 1,5K per month, and I pay in cash 50K as a down payment and all closing costs and take a loan with 500 payments monthly. Let's calculate its Cap Rate:
1.5K * 12 = 18K - Annual Gross Cash Flow
18K / 2 = 9K - Annual Net Cash Flow. We are still applying the 50% rule for simplicity, but let's add the taxes back (let's say - 22%), so the final 'Annual Net Cash Flow' is 10K.
50K (down payment) + 500 (loan points) = 50,5K - Invested Equity
Then, our CoC R:
10K / 50,5K = 0.198 or 19.8%
The same goes for other rates—the higher the number, the better. Usually, a CoC R greater than 8% is considered good enough.
Note: We didn't put mortgage payments in our calculation. If you have a mortgage on your property you should add it to your expenses as well since it's not covered by 50% rule.
Total Net Worth
Another important metric you should take into account as an investor is your annual Total Net Worth, which is calculated as:
$$ Total Equity + Cash Flow $$
When Total Equity is the value of your property or properties minus all loan debts, and Cash Flow is your annual income from your property minus all the expenses (down payment, repairs, maintenance, management, taxes, vacancy periods, and insurance)
For example, let's say I have 3 properties with values - of 150K, 200K, and 250K, and the cash flow from each of them respectively, is 1.5K, 2K, and 2.5K; my loans debts for them are 50K, 100K, and 150K. Let's calculate Total Net Worth:
150K + 200K + 250K = 600K - Property Values
600K - (50K + 100K + 150K) = 300K - Total Equity (Value minus loan debt)
1.5K * 12 + 2K * 12 + 2.5K * 12 = 72K - Generated Income
72K / 2 = 36K - Cash Flow (reducing expenses from Income by 50% rule)
So the Total Net Worth is:
300K + 36K = 336K
Total Net Worth can provide a metric of your financial situation each year, which will help you evaluate how far you are from your goal. For example, if your goal is to become a millionaire in real estate, the above number tells you that you need to increase your equity and cash flow (that can come from buying new properties) or decrease your loan debts and expenses.
70% rule
The last rule worth mentioning is related to the fix-and-flip strategy of buying a property. In this strategy, you buy a property at a lower price, rehab it—repair everything that needs to be fixed and improve it to increase its value - and then sell it at a higher price. To evaluate a fix-and-flip deal, the rough rule of thumb you can use is the 70% rule, which means we should buy a property at 70% of its value after repair.
For example, if the property you are going to buy after repair can cost 200K, then you better buy it at around 200K * 0.7 = 140 K.
Of course, the 70% rule depends a lot on the market you are playing in and the repair needed at the property. In some markets (like Cyprus), it makes sense to increase this threshold to 80% sometimes.
We hope these metrics will help you better understand and evaluate your purchase deals. We used 50% rules for expense calculation for simplicity purposes only, and we didn't include the mortgage payments in our examples. When evaluating the real deals, keep in mind that Price and Cost have different meanings, and the latter should drive your decisions. Price is the amount you pay at your deal, and this is the most apparent number, but the Cost is the amount of money you pay for a product or service over the long term, and this number can make you a winner or a loser. Hence, do your due diligence in calculations, include all possible expenditures, and make sure you really make money when you buy.